United States

Failure to obtain true ownership led to huge tax on sale-leaseback

INSIGHT ARTICLE  | 

The Tax Court in June 2017 entered two orders finalizing amounts owed by Exelon in a recent Tax Court case.[1] Their sum is about $526 million—tax deficiency of about $438 million, plus penalties of about $88 million.[2] In its Form 10-K filed with the Securities and Exchange Commission, Exelon stated that it plans to file an appeal.

The September 2016 decision in this case[3] highlights the risks that accompany claiming ownership of property for tax purposes (Tax Ownership) when another party bears the lion’s share of the economic benefits and burdens of property ownership. Similar Tax Ownership issues arise in many property transactions where both the purchaser and seller have some continued interest in the property.

Tax deferral dispute in the Exelon case

Exelon’s predecessor, Unicom (the former parent company of Commonwealth Edison), sold power plants for about $4.8 billion in 1999, generating about $1.6 billion of gain. It sought to defer tax on this gain by qualifying for like-kind-exchange treatment under section 1031 of the Tax Code.

The like-kind-exchange rules permit deferral of federal income tax that otherwise would be triggered on the sale of some types of business or investment property. Use of this like-kind-exchange tax deferral benefit is particularly common in the real estate industry. Qualifying for the benefit requires acquiring replacement property of like-kind to the property sold. For example, a real estate seller may sell one real property and acquire different one without triggering current tax, if various requirements are met.

Unicom sought to defer taxation of its $1.6 billion gain on the power plant sales under the like-kind rules. It also sought to obtain cash up front and a predictable return on its investment. With the help of its tax advisors, it entered into a number of power plant sale-leaseback transactions. These transactions were intended to both qualify to defer taxation of the $1.6 billion gain and meet with Unicom’s economic preferences. The IRS, however, concluded that they did not qualify for the desired tax deferral because Unicom did not obtain Tax Ownership of the replacement power plants. The Tax Court agreed.

Sale-leaseback transactions

The sale-leaseback arrangements were complex. Their features included: (1) a headlease under which Unicom leased a power plant from its owner-operator for a period of time intended to exceed the plant’s expected useful life in exchange for a large upfront payment from Unicom, (2) a sublease under which the operator leased the plant back from Unicom for a term shorter that of the headlease, which also involved a large upfront payment, but from the operator to Unicom, and (3) an option under which the operator could purchase Unicom’s sublease rights. The parties to the sale-leaseback arrangements intended Unicom’s acquisitions of the headleases to be treated as acquisitions of the corresponding power plants, since the stated term of each headlease exceeded the expected useful life of corresponding plant.

Unicom argued that the power plant acquisitions effected in this manner qualified the $1.6 billion gain on its sale of other power plants for deferral under the like-kind exchange rules. The Tax Court held, however, that Unicom’s sale-leaseback arrangements did not convey Tax Ownership of the corresponding power plants to Unicom. Instead, the Tax Court treated them as loans from Unicom to the respective power plant owner-operators. Because Unicom did not acquire Tax Ownership, Unicom’s interest in these plants did not satisfy the replacement property acquisition requirement of the like-kind exchange rules, and no deferral of the $1.6 billion gain was available.

Benefits and burdens analysis

When courts determine whether an arrangement conveys tax ownership of property, they look to which party bears the benefits and burdens of economic ownership.[4] Courts generally consider multiple factors, and the relevance of a particular factor may depend on the type of asset involved.[5] As a result, the factors considered in sale-leaseback cases typically differ somewhat from those considered in other cases. Courts and the IRS may also apply other doctrines involving consideration of the transaction’s economics, such as economic substance or sham, to challenge a taxpayer’s claim of ownership or sale.[6]   

The benefits and burdens analysis that determines Tax Ownership is a type of substance over form analysis, as the Tax court pointed out in the Exelon case. Whether legal title to property has been conveyed is not by itself sufficient to demonstrate that Tax Ownership was transferred.

Penalties imposed

In addition to concluding that Exelon’s claim of Tax Ownership failed, the Tax Court also imposed penalties. Unicom had received tax opinions from a large law firm, tax advice from a one large accounting firm, and valuation appraisals from another large accounting firm. The court pointed out, however, that the law firm dictated the expected conclusions of the valuation appraisals to the valuation firm in advance. The court also found that valuation appraisals relied on unreasonable assumptions, including assumptions in conflict with those underlying the parties’ financial analysis of the deal. Unicom was financially sophisticated and familiar with the relevant financial analyses. As a result, the court found that Unicom did not rely on the tax advice it received reasonably, and imposed the negligence penalty.

The Exelon case is one of many illustrating that property transactions where a seller and a purchaser each have some continued interest in the property are transactions that may raise Tax Ownership issues. Parties to this type of transaction should consult their tax advisors and consider how the economic benefits and burdens of ownership affect the tax results of the transaction.

[1] Exelon Corp. v. Comm’r, T.C., Docket Nos. 29183-13 and 29184-13 (Orders entered June 22, 2017)

[2] In addition, interest accrued on the tax deficiencies; the Tax Court Orders did not include the interest amounts

[3] Exelon Corp. v. Comm’r, 147 T.C. No. 9 (2016)

[4] See, e.g., Levy v. Comm’r, 91 T.C. 838 (1988) (sale-leaseback); Anschutz Co. v. Comm’r, 664 F.3d 313 (10th Cir. 2011) (stock); Calloway, 135 T.C. 26 (2010) (stock); Grodt & McKay, 77 T.C. at 1221 (1981) (cattle); Windheim v. Comm’r, T.C. Memo. 2009-136 (partnership interest)

[5] See, e.g., Levy v. Comm’r, 91 T.C. 838 (1988) (factors relevant to analysis of sale-leaseback transactions include (1) the investors' equity interest in the property as a percentage of the purchase price; (2) a useful life of the property that extends beyond the lease term; (3) lease renewal or purchase options at the end of the lease term based on fair market value of the property at that time; (4) whether the projected residual value of the property plus the cash-flow generated by the rental of the equipment allows the investors to recoup at least their initial cash investment; (5) whether at some point a “turnaround” is reached whereby depreciation and interest deductions are less than income received from the lease; (6) whether the net tax savings for the investors are less than their initial cash investment; and (7) the potential for realizing a profit or loss on the sale or release of the equipment); Grodt & McKay Realty v. Comm’r, 77 T.C. 1221 (1981) (factors relevant to purchase-sale transaction include: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest in the property is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property); Anschutz Co. v. Comm’r, 664 F.3d 313 (10th Cir. 2011) (for stock transactions factors particularly important include: (1) whether the purchaser bears the risk of loss and opportunity for gain; (2) which party receives the right to any current income from the property; (3) whether legal title has passed; and (4) whether an equity interest was acquired in the property)

[6] See, e.g., § 7701(o) (economic substance); Casebeer v. Comm’r, 909 F.2d 1360 (9th Cir. 1990) (sham)

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